Franked vs. Unfranked Shares?

Many documents and articles I read talk about the benefit of shares paying fully franked dividends. But I don't understand if fully franked shares have a benefit over unfranked shares that pay similar amount. Isn't the tax 'squared up' in the end either way?

I would tend to agree with you. I would prefer (if all I was comparing was dividends) the share with the highest grossed up dividend.

The only difference I can see is if the dividend is fully franked, then you need to come up with less cash at the end of the year to pay tax. (Which also means you do not have that cash during the year to invest with.)

My accountant would tell me to go for share 1 with the FF component, but aren't they the same benefit?

Curious if FF dividends is a marketing concept (similar to negative geared real estate used to be), but offers no real benefit over an unfranked share paying equivalent amount?

Thanks and regards, Ilori

Click to expand...

Hi Ilori,

Share 1 has already paid 2.57% in tax on top of the 6% paid to you (30/70 x 6% is the franking credits/tax already paid) so total return 8.57%
Share 2 is a flat 8.5%

If your paying 30% tax, for share 1, the company has already paid tax on your behalf, whereas share 2 you will pay tax when you do your tax return.

If your paying 15% tax, share 1 will give you 1.28% back in tax!!! Whereas share 2 will still get you to pay tax when you lodge your tax return.

The main point of view is that you either pay tax now at 30% (and then potentially not have to pay more) or pay later, obviously everyones situation is different and this has to be taken into account.

Saying that, your accountant may like FF shares as they can show that they are adding value. It's a bit like mickey mouse planners blending multi-manager funds to show they add value by blending a conservative fund, a balanced and a growt fund.

Far as I can see, assuming the gross-up amount is same – unfranked dividends give me a little more cashflow upfront and some control over when the tax is paid, whereas FF give no flexibility as tax deducted at source.

You may be right AsxBroker, FF might be a way of trying to show some value add… “hey, these FF shares I recommended saved you some tax, I'm earning my fee".

If there is a benefit of FF, would love to hear... curious as to whether I'm missing something or not.

I agree with you that there's no difference (other than timing and convenience) between a FF dividend, and an unfranked commensurately higher dividend.

The bottom line is that the same amount of tax will be paid in either case. A big 'shock ' at the end of the year is unwelcome from a cash management and blood pressure point of view, but nothing a bit of personal discipline can't fix. You may find that paying all the tax at the end of the year affects your quarterly tax installment rate for the next year, but I'm not 100% sure about that.

To my mind, here's the big benefit of a FF dividend:- if a company is paying a FF div, then it means they are paying lots of tax. If they're paying lots of tax, then there's a reasonable likelihood that their profits are real. If all a company is doing is handing their shareholders back their own money, then chances are they won't be sending anything to the taxman. If they're conjuring accounting profits out of thin air, chances are they won't be sending anything to the taxman. Paying tax is a useful indicator that the business activities are real, and that even after all the creative accounting, they still had real profits left at the end of the day.

Some exceptions to that - property trusts and companies with substantial offshore revenue come to mind. But in general it's not a bad rule of thumb to add into the mix.

"...if a company is paying a FF div, then it means they are paying lots of tax. If they're paying lots of tax, then there's a reasonable likelihood that their profits are real. If all a company is doing is handing their shareholders back their own money, then chances are they won't be sending anything to the taxman. If they're conjuring accounting profits out of thin air, chances are they won't be sending anything to the taxman. Paying tax is a useful indicator that the business activities are real, and that even after all the creative accounting, they still had real profits left at the end of the day".

You better read this...

"Enron Corp's bankruptcy is a disaster of epic proportions by any measure - the height from which it fell, the speed with which it has unraveled, and the pain it has inflicted on investors, employees, and creditors. Virtually all the checks and balances designed to prevent this kind of financial meltdown failed. Unless remedied, this could undermine public trust, the capital markets, and the nation's entire equity culture."

When a company makes $1.00 of profit (profit for tax purposes) and pays $0.30 as income tax, it records the $0.30 in a franking account. The $0.30 is paid in cash to the ATO; the franking account is only a record of what was paid.

When the company pays a dividend, either in the same year or later, it may attach a franking credit from its franking account, in proportion to the tax rate. So each $0.70 of dividend may have $0.30 of franking credit attached. The franking amount is again just a record, only $0.70 of cash is paid - such a dividend is called a franked dividend.

An eligible shareholder receiving a franked dividend declares the cash amount plus the franking credit as income, and is credited with the franking credit against their final tax bill. The effect is as if the tax office reversed the company tax by giving back the $0.30 to the shareholder and had them treat the original $1.00 of profit as income, in the shareholder's hands, like the company was merely a conduit.

Thus company profits going to eligible shareholders are taxed just once. Profits are either retained by the company and taxed there at the corporate rate, or paid out later as dividends and instead there taxed at the shareholder's rate.

Dividends may still be paid by a company when it has no franking credits (perhaps because it has been making tax losses), this is called an unfranked dividend. Or it may pay a franked portion and an unfranked portion, known as partly franked. An unfranked dividend (or the unfranked portion) is ordinary income in the hands of the shareholder.

In summary ...

The income that has been paid out to shareholders is generally in the form profits, which has already had tax paid on it. As such the distribution ie the cents per unit (CPU), either will or won’t have an imputation credit. This means that the amount of the distribution is going to be the same, and not grossed up as per your example.

There are various tax deductions that companies are entitled to claim, including losses made in all previous years. This means that a company does not always pay the full rate of tax on its profits in a particular year.

The result may be that it has not paid enough tax to attach a tax credit to the whole of the dividend that it pays to shareholders. This means that a tax credit is attached to only part of the dividend which is known as fully franked and the other portion is unfranked. Unfranked dividends are those to which no tax credits apply. This combination is sometimes referred to as partly franked dividends.

"Enron Corp's bankruptcy is a disaster of epic proportions by any measure - the height from which it fell, the speed with which it has unraveled, and the pain it has inflicted on investors, employees, and creditors. Virtually all the checks and balances designed to prevent this kind of financial meltdown failed. Unless remedied, this could undermine public trust, the capital markets, and the nation's entire equity culture."

"...analysis of Enron's financial documents by Citizens for Tax Justice finds that Enron paid no corporate income taxes in four of the last five years-- although the company was profitable in each of those years." (and the year that it did pay tax was hardly a bean).

It confirms the point I'm making -- Enron was claiming to be profitable, but it's tax returns indicate otherwise.

If you're cheating your shareholders, you're unlikely to be paying the taxman way way more than you should. You'll be honest with the taxman because it suits you, but dishonest with the shareholders. That's exactly what Enron did.

In the examples that you gave where fully franked wins, they're using the same rate of return, $5000, and either having it paid FF or Unfranked. In the case where the $ amount is the same, of course FF will win out as tax will effectively have been paid before reaching the investor.

I haven't really sorted the maths out for it though, so a franking credit may end up changing the results, upon which you are correct. To my understanding though it's the same as asking which of the following is better?

$5000 dividend fully franked (with an associated 30% grossed up amount of $2143, and subsequent franking credit of the same amount) OR $7143 unfranked dividend.

At the end of the day they seem to end up equal. Just that the rate of return can be quoted differently

You've got the right idea, just a couple of problems - one small, the other fundamental.

First, for a $20,000 FF div, the franking credit would be $8572, not $6000. Doesn't make any difference to your illustration, but is just a minor detail.

But the big thing is not to concentrate on the assessable income in each case, but the actual income. In the first case (taking your $6000 as correct, which it might well be in the case of a partially franked share):

Thanks very much everyone, looks like consensus is that they are effectively the same with respect to final tax position. This is what I would have expected, still, FF dividends seem to get better publicity.

A couple of points:

1. Tropo's comment about FF being some comfort that the company is generating a profit is a good one (noted, it is no guarantee, still, good point)

2. Unfranked dividends may be better than franked in that:
a) give more actual cash during the year
b) have some flexibility as to when tax is paid (according to individual circumstances)

3. Just a thought, I wonder if the concept of FF dividends achieved some popularity historically, because (I think?) they were brought in to stop double taxation... so they would have been great in that sense. Maybe they still have a following from that perspective (eventhough no practical advantage).

4. Another thing - slightly off the main point - but, as I understand it, dividends can be from different structures. If from a Company, then the dividends are profits paid to shareholders, but, if from a Trust (eg. Property Trust) then the dividend is a distribution to beneficiaries. Companies and Trusts pass money to shareholders/beneficiaries in slightly different ways - interesting little difference. Not sure if I'm completely right in this - happy to be corrected if wrong.